Is Sino-Ocean Group Holding (HKG:3377) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Sino-Ocean Group Holding Limited (HKG:3377) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Sino-Ocean Group Holding

What Is Sino-Ocean Group Holding's Debt?

The chart below, which you can click on for greater detail, shows that Sino-Ocean Group Holding had CN¥85.7b in debt in June 2021; about the same as the year before. However, because it has a cash reserve of CN¥32.8b, its net debt is less, at about CN¥52.9b.

How Strong Is Sino-Ocean Group Holding's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sino-Ocean Group Holding had liabilities of CN¥126.2b due within 12 months and liabilities of CN¥69.3b due beyond that. Offsetting these obligations, it had cash of CN¥32.8b as well as receivables valued at CN¥61.9b due within 12 months. So its liabilities total CN¥100.8b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥11.3b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Sino-Ocean Group Holding would probably need a major re-capitalization if its creditors were to demand repayment.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Sino-Ocean Group Holding has a fairly concerning net debt to EBITDA ratio of 7.4 but very strong interest coverage of 48.9. So either it has access to very cheap long term debt or that interest expense is going to grow! Shareholders should be aware that Sino-Ocean Group Holding's EBIT was down 21% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sino-Ocean Group Holding can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Sino-Ocean Group Holding reported free cash flow worth 7.4% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Sino-Ocean Group Holding's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. After considering the datapoints discussed, we think Sino-Ocean Group Holding has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with Sino-Ocean Group Holding (including 1 which is a bit unpleasant) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.